Speech
Economic Trends and Policies

Once again it is a pleasure to have this opportunity to speak to members of the ABE.
I believe – I hope correctly – that business economists share our
interest in seeking out practical policy responses to our problems.

Today, I would like to offer some comments on current economic trends and their implications
for policy. They will have a familiar ring to many of you.

The Past Year

Looking back for a moment, by most measures 1994 was a very good year for the Australian
economy:

despite the drought, GDP appears to have grown by 5 to 6 per cent;

employment increased by over 280,000 or 3½ per cent;

unemployment declined by 130,000, including a fall of more than 60,000 in the number
of long-term unemployed;

the unemployment rate fell by 1¾ percentage points to a touch under 9 per
cent;

business investment at last took off, increasing by over 20 per cent in real terms;

business profits increased by around 10 per cent, and the profit share of national
income continued to hover around its historical levels; and

underlying inflation remained around 2 per cent.

The combination of rapid growth and low inflation was most welcome, leading as it
did to a sharp reduction in unemployment. It was only possible, however, because
we had considerable spare capacity to begin with. As that capacity is taken
up, it is natural – and necessary – for the growth rate to slow.
That is now happening.

Yet, despite these trends, there appear to be popular concerns that all is not well
– that we are in danger of lapsing into our old boom/bust ways, when
a spurt in growth caused both inflation and the current account to career out
of control. These are legitimate concerns for policy makers at this time but I believe
– more than some others perhaps – they will be managed satisfactorily.

That management has begun already, with interest rates being raised on three occasions
late last year. Those largely pre-emptive rises have helped to settle the exuberance
of consumers and home buyers which, six months ago, was threatening to bubble
over.

That, of course, was the purpose of the interest rate rises. To make further inroads
into unemployment, we need sustained economic growth, not an inflationary ‘dash’.
Since the recovery commenced in mid 1991, real GDP has grown by close to 15
per cent; employment is up by around 500,000 (6½ per cent) since its
low point in mid 1993. This recovery would not last, however, if total spending
were to continue to grow at anything like the 8 per cent recorded in the year
to the September quarter: that would lead inevitably to major inflation and
current account worries, followed by higher interest rates and unemployment.

Sentiment generally is now less exuberant and – assuming it stays that way
– this should help to slow the growth in spending during 1995. So far,
the most visible slowing has occurred in the housing sector, and this probably
owes more to the maturity of the housing cycle than it does to the relatively
modest increase in mortgage rates since last August (less than two percentage
points for most mortgage borrowers). For more than two years now, dwelling
commencements have been running well ahead of underlying demand, presaging
a fairly pronounced correction which still has some way to go.

How quickly the pace of growth slows will have important implications for inflation
down the track and, therefore, for monetary policy. Growth does appear to be
slowing but – with the notable exception of housing – most sectors
are continuing to grow quite strongly, at least to this time.

How much of a slowdown should we be looking for? We can only make informed guesses
about these things, but the notion of the long-term potential (or underlying)
growth rate provides a couple of clues. This is the highest rate at which the
economy can grow without running into inflation and current account constraints.

No-one knows exactly what Australia's long-run potential growth rate is. Some
commentators put it around 3 per cent. This seems too pessimistic to me, particularly
given signs that productivity is on the rise. After stagnating for several
years, investment is now growing again and adding to the nation's capital
stock. Anecdotal and other information also point to better productivity performances;
in the 1980s, output per hour worked grew at an annual rate of just over 1 per cent
but in the past five years it has risen by around 2 per cent a year
(see Graph 1). Perhaps it is too early to conclude
that this is a permanent improvement, but the structural changes of the past
decade must have raised efficiency in many sectors of the economy.

Graph 1

Traditionally, potential growth rates have been viewed as a function of two main
components – namely, productivity growth and workforce growth. Over coming
years, Australia's workforce is projected to grow by nearly 2 per cent
per annum. Predicting labour productivity growth is more difficult, as I have
just noted, but with the right focus we should be able to maintain a rate around
2 per cent per annum. On these assumptions, a long-term potential growth rate
of around 4 per cent would not seem an unreasonable aspiration for Australia.

You should not infer from these remarks that the Reserve Bank has a ‘growth
target’. We do not. Apart from the hypothetical nature of such targets,
we recognise, more than most I suspect, that policy cannot be calibrated to
achieve and hold any predetermined growth rate.

Instead, what we have is a view about how fast the economy can grow over time without
being blown off course by inflation or other pressures. It cannot be a fixed
view. If, because of surplus capacity or better long-term productivity performances,
a faster growth rate was consistent with maintaining low inflation, we would
be more than happy to accommodate that growth. Similarly, if pressures on resources
were such that maintaining low inflation required slower growth, then monetary
policy has to contribute to that outcome. If, over the medium term, the prospects
for growth consistent with low inflation were judged to be inadequate in terms
of employment or other objectives, then the focus should be on structural and
competition policies aimed at boosting productivity and exerting more discipline
on price and wage setters, not on trying to run the economy faster than its
inherent capacity.

For present purposes, however, the key point is that if the sustainable growth rate
is not 3 per cent, it is not 5 or 6 per cent either. Some slowing from recent
growth rates is, therefore, needed. This is occurring but it is not clear,
at this time, by how much.

As you know, the Reserve Bank has a major responsibility to keep inflation low. But
we must also take account of the impact of our actions on output and employment
over the policy time horizon. So we spend a lot of time monitoring the various
indicators, weighing up the risks for inflation and growth of policy miscalculations,
and coming to what are often on-balance judgments. Currently, views about such
things as the outlook for the world economy, the duration of the drought, and
the shape of the forthcoming budget must also be factored into policy deliberations.
There is nothing new about that process, which is ongoing.

What I would like to emphasise is that should additional data and/or particular developments
lead the Bank to a judgment that more (or less) needs to be done on monetary
policy, we would follow through on that judgment, irrespective of any overlapping
election or budget timetable. This should be more widely appreciated than it
appears to be at present. I will say a little more about fiscal policy later,
but it follows from what I have just said that while a ‘good’ budget
could have implications for monetary policy, it would not necessarily obviate
the need for further interest rate action.

Some of these issues – and the challenges they pose for business decision makers
as well as for policy makers – will become clearer as we look more closely
at the pressures building on inflation and the current account.

Inflationary Pressures

The Reserve Bank's objective is to hold
underlying inflation to an average of 2 to 3 per cent over a run of
years. This would, in our view, lead to better investment and saving decisions
than would occur in an environment of higher inflation.

The 2 to 3 per cent objective was never a narrow band in which we believed inflation
must, or necessarily can, be maintained at all times and in all circumstances.
That would be too narrow and too constraining a target, given the cyclical
and other influences on inflation. Rather, the ‘2 to 3 per cent’
specified an inflation rate we would aim for over the medium term: success
would be reflected in an average inflation rate of ‘2 point something’.

An alternative objective which has been suggested for Australia is that we maintain
an inflation rate comparable with the average of our major trading partners.
This formulation provides a useful reminder of our growing exposure to global
markets and the importance of international competitiveness. On the other hand,
it downplays domestic considerations. We pursue price stability because our
economy will operate better with low inflation, and the average of our major
trading partners may not always provide the ‘best practice’ standard.
If some of our trading partners happen to run inflation rates that are clearly
too high (such as China's 20 per cent plus rate), that does not mean Australia
also should run high inflation rates; our low-inflation objective should not
be hostage to policy makers in other countries.

The Bank's objective is expressed in terms of underlying inflation, which is less volatile than the inflation rate
measured by the overall Consumer Price Index (CPI). The latter has averaged
less than 2 per cent per annum over the past three and a half years, but increased
by 2½ per cent over the year to the December quarter. We expect this
measure to jump sharply when the figure for the year to the March quarter is
released in a few weeks time, and to hover around 4 to 5 per cent during 1995.
This jump will largely reflect the flow-through of the rises in official interest
rates which occurred last year; to give an indication of the magnitudes involved,
a one percentage point increase in mortgage and personal loan rates is estimated
to boost the CPI directly by between 0.6 and 0.8 of a percentage point.

We are, then, about to observe a graphic demonstration of how the usual CPI measure
of inflation can depart from – and be an inappropriate guide to –
the ‘underlying’ rate. For macro-economic policy purposes, what
matters is the underlying rate, that is, the rate of increase in prices which reflects
the balance between supply and demand pressures in the economy, after the effects
of any policy measures designed to change that balance have been excluded.

That is why we have focussed on the underlying rate as (now) published by the Statistician
(and based on longstanding Treasury methodology). It has been our focus during
the period when the underlying rate was above the overall CPI rate; it will,
of course, continue to be our focus during the year ahead when it is expected
to be somewhat below the overall rate. Whether others are similarly focussed
over this period will be an interesting test of the maturity of our economic
commentators.

Underlying inflation was running at about 2 per cent in the year to the December
quarter. We expect this to rise over the quarters ahead, and to exceed 3 per
cent during the course of 1995. Several factors lie behind this forecast, including
the absorption of spare capacity, an upward drift in wage rises, and increases
in some commodity and materials prices. Were it to persist, the recent decline
in the exchange rate would be another contributing factor.

The prospect of underlying inflation exceeding 3 per cent is not, in itself, a cause
for alarm. The natural dynamics of inflation over the course of the business
cycle can be expected to generate some pressures on the upswing. It does not
represent any weakening of our resolve to maintain low inflation. Nor does
it mean that inflation is going off-track over the medium term.

It would be a different story if underlying inflation above 3 per cent was set to
become entrenched. But that is not the situation, and it is the aim of policy
to avoid that situation. To that end, interest rates were raised a total of
2.75 percentage points last year while underlying inflation was still at 2
per cent. Monetary policy remains committed to the 2 to 3 per cent objective
and, if necessary, will be adjusted to deal with departures from that objective.

Because labour costs tend to dominate total production costs, the most critical determinant
of the future path of underlying inflation will be the size of wage and salary
increases. Over the past year, the growth in ordinary-time earnings has quickened
a little, to around 4 to 5 per cent (see Graph 2). This rate of increase, together
with current rates of productivity growth and profit margins, is broadly consistent
with underlying inflation of 2 to 3 per cent. That situation, however, is quite
tight; it has no room for further slippage, or for any slowing from current
rates of productivity growth.

Graph 2

I think some commentators assume too readily that there will be major slippage on
wages. The past couple of decades have demonstrated clearly that wage restraint
delivers strong jobs growth, and vice versa: that lesson has not gone unheeded.
Moreover, attitudes and institutional arrangements are very different today.
Having to compete in global markets and to contend with tariff reductions and
other structural changes helps to concentrate many minds on the importance
of wage restraint. And, despite ongoing wrangles over some aspects, the enterprise
bargaining arrangements do appear to be delivering better wage outcomes than
the previous centralised system.

Monetary policy – in conjunction with these other policies – also plays
a role in shaping an environment conducive to continued price and wage restraint.
More people now understand that low inflation comes at too high a cost to be
given up at the first whiff of trouble.

To make much the same point in different words, it would be a terrible indictment
of everyone involved – policy makers, employees and employers –
if serious wage pressures were to break out while unemployment remained around
9 per cent. That would imply that the natural rate of unemployment (the Non-
Accelerating Inflation Rate of Unemployment or NAIRU) was higher than 9 per
cent! In the United States, where the economy has been growing strongly for
several years and the unemployment rate has slipped below 5½ per cent,
wage increases have remained around 3 per cent, at least to this time. Comparisons
with other countries are seldom straightforward, and different approaches to
social safety nets complicate comparisons of our natural rate of unemployment
with that in the United States. But the basic point is clear: Australia needs
to be able to reduce its unemployment well below current rates without triggering
higher inflation.

One argument which has been used recently to justify higher wage claims is that workers
should be compensated for increases in mortgage interest rates (and in taxes
for that matter). I can well understand the desire of employees to offset the
effects of higher mortgage interest rates on their disposable incomes. But
that does not make the argument correct: its logic is that interest rates (and
taxes) should not be raised because such increases would cause a wages surge
and higher inflation. Accepting that logic would lead either to policy gridlock,
or to the sort of showdown between policy and labour markets which would leave
everyone a loser.

If higher interest rates were to lead to larger wage outcomes, inflationary pressures
could be expected to intensify, in the short run. But higher labour costs would
increase business costs and squeeze profits. That would be bad for investment
and jobs. If employers passed on the higher wage costs, prices would move higher,
necessitating further interest rate rises – again with adverse effects
on employment.

The simple fact is that when spending (especially private and public consumption
spending) is growing at too fast a pace – as it has been – then
that spending needs to be curbed through policy tightenings of one kind or
another. Seeking to protect incomes and spending from the effects of such measures
will only increase the pressure for even more policy tightening, with even
higher costs in terms of lost jobs. This should be remembered as the effects
of past interest rate rises flow through the Consumer Price Index over the
next couple of quarters.

I should explain, as an important footnote to this discussion on wages, that I talk
of ‘wage’ restraint as a shorthand for restraint on wages
and salaries across the board, including the salaries of managers
and executives. The latter appear to have been rising somewhat faster than
wages. Whatever the realities of life in an international market for executives,
another reality of life is that most ordinary people notice the example set
by their bosses. If executives pay themselves increases that are out of line
with the increases paid to their employees, they can hardly complain if this
is noticed and provokes higher wage claims.

Current Account Pressures

The other major storm cloud to be negotiated is the rising current account deficit.
You will recall the Treasurer indicated at the end of January that the current
account deficit in 1994/95 was likely to reach $26 billion (or 5¾ per
cent of GDP), compared with the budget time forecast of $18 billion (4 per
cent).

Several factors are responsible for this increase of $8 billion. The effects of the
drought on rural exports are estimated to have contributed about $1.4 billion.
Exports of cereals have been the hardest hit, with the wheat crop only half
that of last year. With a return to more normal seasonal conditions, rural
exports should rebound solidly in 1995/96.

The much faster-than-forecast growth in domestic spending appears to have absorbed
some manufactured goods that might otherwise have found their way to export
markets. In the second half of 1994, growth in exports of elaborately transformed
manufactured goods slowed sharply, after a number of years of strong growth.
To the extent that this apparent diversion to domestic markets reflects the
recent strength of domestic demand, it should be reversed as the pace of growth
slows.

The main cyclical influence on the current account deficit, however, has been
on the imports side. Here, the faster growth in domestic spending is estimated
to have contributed about $5 billion of the $8 billion increase. Over the second
half of 1994, imports of capital goods were 37 per cent higher than in the
corresponding period a year earlier; imports of intermediate and consumption
goods both rose by about 15 per cent over the same period.

The surge in investment spending is to be welcomed, and will expand our capacity
to boost future output and exports. In the absence of a pick-up in domestic
saving, however, this investment surge translates into an increase in the current
account deficit.

Finally, higher world interest rates, leading to higher net debt service payments,
have also contributed to the higher current account deficit, adding about $1½
billion to the budget time forecast.

In summary, the increase in the forecast 1994/95 current account deficit can be explained
in terms of the strength of the cyclical upswing, and fluctuations in seasonal
conditions and world interest rates. Behind those explanations, however, lies
a more fundamental causation, namely the persistent imbalance between saving
and investment: as a nation, we spend far more than we earn. If we were to
adjust the present estimates for the effects of weather and world interest
rates (over which we have no control), and to assume more normal investment
and growth rates, we would still be left with a current account deficit equivalent
to around 4½ per cent of GDP.

This is the structural dimension of our current account problem. It is perhaps
best illustrated by the fact that net service payments on foreign liabilities
have risen to the point where they alone now represent about 4 per cent of
GDP (see Graph 3).

Graph 3

I have said before that, while there can be no precision in these matters, we could
all feel a lot more comfortable if the average current account deficit over
the business cycle was somewhat lower. A deficit which averaged around
3 per cent, for example, would stabilise the ratio
of net foreign liabilities to GDP around current levels.

So long as we remain so dependent on foreign savings, for which we must compete in
international capital markets, we will remain vulnerable to adverse swings
in market sentiment. The most obvious vulnerability is our exposure to a sharply
falling exchange rate. We know from past experience that the markets can sometimes
turn sharply against Australia and the $A, not always for well-based reasons.
Downward pressure on the exchange rate, if it were to persist, would add to
inflationary pressures, and force the authorities into tough policy measures.
The best counter here, of course, is to pursue fundamentally sound policies
as a matter of course.

The necessary thrust of those policies seems straightforward enough. The cyclical
dimension of the current account problem will be assisted by measures to remove excess
demand pressures. In addition, we need, over time, to run a significant surplus
on the balance of trade in goods and services – to spend less than we
produce – which means increasing our national savings (to address the
structural dimension).

The budget has a role to play on both fronts. First, by restraining private and/or
public spending, it can help to slow economic growth to a more sustainable
rate, thereby easing pressures on both inflation and the current account. The
extent of the budget deficit reduction, and the manner in which it is achieved,
are obviously important here. I would add only that, given the stage of the
economic cycle, the next budget should, on macro-economic grounds, be moving
much closer towards balance.

Viewed in these terms, a ‘good’ budget could be seen as easing the pressure
for possible further monetary policy tightenings. That is true. But even a
‘good’ budget would not necessarily rule out further interest rate
adjustments. For one thing, we could not be sure that such a budget would cause
the economy to slow sufficiently, particularly given the favourable effects
it could have on confidence generally. The implications for monetary policy
of a ‘bad’ budget are, however, rather clearer.

As for reversing the decline in national saving (and reducing our dependence on foreign
saving), the broad options are well understood. Greater provision for personal
retirement is probably the main means of raising, over time, the level of private
saving. It is in the area of public-sector saving, however, that the largest
trend decline has occurred (see Graph 4) and where, in the short term, the
greatest scope exists to boost national saving – through the reduction
and elimination of budget deficits.

Graph 4

On the basis of current Government projections, the budget deficit would decline
from 2.7 per cent of GDP in 1994/95 to a surplus in 1996/97
(see Graph 5). This would represent an improvement
in national saving of about three percentage points in two years. I am confident
that the Government will deliver an improvement of at least this order.

Graph 5

Conclusion

It is good that jobs are being created in large numbers – almost 500,000 since
July 1993. The Reserve Bank is interested in job creation, not just because
it is part of our charter but, more fundamentally, because that is the main
route to higher living standards for ordinary Australians. But it has to be
sustained job creation. This means solid growth sustained over a lengthy period,
without the recovery self-destructing or having to be aborted prematurely in
a surge of inflation or current account pressures.

Monetary policy was tightened in 1994 to help achieve a rate of growth consistent
with low inflation and, until this objective is assured, further tightening
has to remain on the agenda. The forthcoming budget also has a role to play
in moderating inflationary pressures and, more importantly, in helping to lift
longer-term national saving.